Our firm routinely meets with prospective clients who have encountered financial trouble after “cosigning” or “guaranteeing” a loan for a family member or friend that went into default. Many times they misunderstood the extent of their liability at the time that the loan was executed, or assumed that the lender would only pursue them for the debt after exhausting collection attempts from the primary borrower. It is important to know the reasons why a lender would require a cosigner, and the implications for the consumer who cosigns before agreeing to guarantee the debt.
WHY IS A COSIGNER NECESSARY?
Lending money is as much about evaluating risk as it is about obtaining a profit. If the lender believes that the borrower may be at a high risk of default – due to credit history, inconsistent employment, or other concerns – then it is going to take steps to reduce that risk. While charging a higher interest rate and demanding a larger downpayment may help to alleviate the risk of default (or reduce the amount of debt to be collected in the event of default), it still may not be enough for the lender to justify the loan. In many situations, the lender will insist upon the borrower to obtain a creditworthy cosigner before the loan will be granted. By requiring a cosigner, the lender now has two (or more) individuals who are equally responsible for payment of the debt. This reduces the risk of default, and makes the loan less risky. In addition, the cosigner will often have superior credit, which they will protect at all costs by making payments on the loan in the event that the primary borrower is unwilling or unable to do so. Ideally the primary borrower will make all scheduled payments in a timely basis, which will enhance their credit and reduce or eliminate the need for a cosigner in the future.
WHAT ARE MY OBLIGATIONS AS A COSIGNER OR GUARANTOR?
As a cosigner or guarantor (these terms are often used interchangeably), you are “guaranteeing” payment of the debt. This does not mean that you are simply vouching for the character of the borrower. Instead, you are saying that if the primary borrower does not make the payments, you will be responsible for the entire debt.[i] While many consumers believe that there is some priority between being a primary borrower or “secondary signer”, the law and the contract make no such distinction. The debt will be reflected on both credit reports, and any late payments or defaults will impact both credit scores. Unfortunately, many contracts lack any notice requirements for cosigners, meaning that they may not find out that the debt has gone into default until it is too late to correct the problem. I have talked to numerous parents and grandparents who have cosigned vehicles for children and grandchildren, and were not notified that there were any problems on the loan until the vehicle was repossessed and they were contacted about collection of the deficiency claim. Due not be misled by a lender or salesperson as to your legal liability when you cosign or guarantee a loan. A frequent complaint of prospective clients is that they felt “compelled” to cosign a car loan because their family member was already at the dealership with their vehicle selected, and that the only hang-up preventing completion of the transaction was their signature. This is a common pressure tactic at some dealerships, but the potential disappointment of a child or grandchild should not overcome common sense.
HOW CAN I PROTECT MYSELF IF I GUARANTEE A LOAN?
The best way to protect yourself is to never cosign a loan in the first place. As my father has told many clients, “[b]ankers make their living by assessing risk and making loans. If a person who does that for a living doesn’t think that your child can afford the loan, who am I to second-guess how they do their job.”[ii] But if you disregard this advice and choose to cosign, there are some measures that can be taken to help protect yourself. First of all, make sure that the primary borrower does their homework. In the event of a car purchase for instance, make them secure financing before they ever set foot on the car lot. In this way, they (and you) will know the loan terms in advance of the purchase. This will also help to establish how much they can afford and what they can spend. It will also prevent a high pressure point of sale transaction, where financial common sense gives way to that must-have, “new car smell.”
Secondly, obtain the financing through a bank or credit union that you already have a relationship with, and make sure that joint billing statements are sent out. This will allow you to monitor the payments by the borrower, so that you can make sure that the loan does not go into default. Local lenders are more likely to notify cosigners when there is a problem so that they can take steps to protect themselves. In the alternative, you can insist that the monthly statements come to you as the cosigner, and the primary borrower send the money to you. If the primary borrower feels that this is intrusive or demeaning, then you can allow them to seek other means of obtaining financing without your guarantee. In the event that the borrower is not local, you may have to monitor your credit report to verify compliance with the loan terms.
Finally, if it appears that loan may be headed for default, you may want to pay off or refinance the loan with a loan in your own name. This will prevent any dings on your credit score. You can then set up loan terms directly with the cosigner where they pay you directly, or sign the collateral over to you.
While this may seem like a condemnation of the “cosigning process”, it is a more appropriately a tutorial on what can go wrong, and the significant risks involved. Cosigning a loan yields little tangible benefit to the cosigner or guarantor, yet at the same time imposes significant risk. Since the cosigner is usually the one with superior credit, and better resources, they will be the first collection target if something goes wrong and the loan defaults. Not only does this cause financial hardship, but it can often impair the personal relationships between the primary borrower and cosigner. As a potential cosigner, you have no reason not to assess these risks in the same manner that the prospective lender assessed the risks of default.